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Chapter 1

The end of the Great Stability

Our economic world changed dramatically in 2008 – a year which must go down as one of the most turbulent in the modern history of the global economy. The first half of the year was dominated by a strong surge in energy, food and other commodity prices – with the oil price rising to a peak of $147/barrel in July. Inflation and business costs were pushed up in most countries around the world, squeezing consumers and putting pressure on company finances. In the second half of the year, we experienced the full force of the financial crisis, which had been gathering momentum for over a year. Extreme turbulence in the financial system led to the failure of Lehman Brothers in September 2008 and the near collapse of other banks and financial institutions. Around the world, governments and central banks were forced to step in with bailouts and a raft of other emergency measures to prevent a total meltdown of the financial system.

Two years before this financial turmoil was unleashed in the autumn of 2008, I had left my job as Chief Economist at British Airways (BA) and joined the Bank of England Monetary Policy Committee (MPC) – the body which sets interest rates for the UK economy. While there was some discussion of financial risks on the MPC, the main focus of the economic debate in 2006 and 2007 was not on how unstable the economy might become, but why it had been so stable for so long. The prevailing view at that time was that the United Kingdom and other Western economies were experiencing a period of Great Stability – characterized by steady sustained growth and low inflation.

I joined the MPC just as this period of stability was coming to an end. With hindsight, I should have been prepared for that as turbulent economic conditions had been following me around throughout my career. I started my first job as an economist at the Confederation of British Industry (CBI) in 1986, just at the start of the major boom–bust cycle which dominated the late 1980s and early 1990s. I was responsible for the CBI’s economic commentary and policy recommendations over a period which saw double-digit inflation, interest rates at 15%, a major recession, record public borrowing and the trauma of the United Kingdom leaving the European Exchange Rate Mechanism (ERM) less than two years after joining.

This pattern was repeated during my time at BA from 1998 to 2006 – which included the most severe downturn in the history of global aviation following the 9/11 attacks on the World Trade Centre. This massive shock to the airline industry threatened the survival of BA, and radical business surgery was needed to achieve a turnaround – including the loss of 13,000 jobs, nearly a quarter of the company’s total workforce.

So perhaps I should not have been surprised when the early signs of the financial crisis began to emerge after less than a year of my time at the Bank of England. As the minutes for the August 2007 MPC meeting recorded:

The main news this month in financial markets had been the sharp deterioration in credit markets and the associated falls in equity prices and changes in market interest rates. A trigger for this turbulence appeared to be renewed concerns about the US sub-prime mortgage market, the losses of some prominent hedge funds, and the revisions to the ratings of some mortgage-backed securities; this had led to a reduction in demand for products such as sub-prime mortgage-backed securities and collateralised debt obligations…. It was not clear how far the downturn in financial markets would go, nor how long it would persist.

These financial market tensions led to the demise of the UK bank Northern Rock in the autumn of 2007 and major banks like Merrill Lynch, Citibank and UBS started to announce large losses and debt write-downs. Yet, at the start of 2008, views about the growth of the world economy remained remarkably positive. The IMF’s January 2008 economic update predicted that the world economy would grow on average by over 4% in the coming calendar year. That would have been a healthy rate of growth by longer-term historical standards, even though it represented a slowdown from the boom-time global economic conditions of 2004–7.2

A year later, in January 2009, in the aftermath of the collapse of Lehman Brothers and all the other financial turbulence in autumn 2008, things looked very different. The outlook was for recession across the world economy with sharp declines in output in all the major Western economies. Under the headline ‘Global Economic Slump Challenges Policies’, the IMF predicted that world growth would be just 0.5% in the year ahead, the weakest year for global growth since 1950 at least.3 In fact this was an underestimate of the scale of the downturn – world GDP actually fell in 2009 for the first time since World War II.

Going back to the start of the 20th century, there are only two other peacetime years when the outlook for the world economy deteriorated as dramatically as in 2008. One is 1930, which marked the onset of a prolonged depression in the United States and Europe after the Wall Street Crash of 1929, bringing to an end the prosperity of the ‘roaring twenties’. The other is 1974, when the long post-war boom came to an end amidst rampant inflation, rocketing oil prices and financial turbulence. That year ushered in a long period of economic turmoil in many economies which continued until the mid-1980s.

The Great Stability

As in the 1930s and the mid 1970s, policymakers were unprepared for the big change in the economic climate in the late 2000s. The long period of healthy growth and low inflation since the early 1990s had led to the expectation that big swings in the economy were a thing of the past. In his 2004 Budget speech, the UK Chancellor of the Exchequer Gordon Brown proclaimed:

Britain is enjoying its longest period of sustained economic growth for more than 200 years… the longest period of sustained growth since the beginning of the Industrial Revolution.4

This optimistic assessment reflected the positive performance of the British economy since the early 1990s. UK economic growth averaged 3.3% per annum between 1993 and 2007 – very impressive by past historical comparisons and in line with the growth rate Britain had achieved in the post-war golden age from the late 1940s until the early 1970s. Even in the weakest year for UK economic growth between 1993 and 2007 – in 2002 – GDP grew by 2.4%, despite a weak global economy in the aftermath of the 9/11 attacks. (This ‘weak’ GDP rise in 2002 is still stronger than any year of growth we have seen so far since the financial crisis!)

Alongside this healthy rate of economic growth, low and stable inflation reinforced the widespread perception of economic stability. For two decades, from the early 1970s until the early 1990s, UK policymakers had battled to subdue inflation. The annual rate of increase in prices had hit a peak of nearly 27% in the summer of 1975 – averaging over 13% in the 1970s and running at 6% through the 1980s. But from 1993 until 2007 – with monetary policy explicitly targeting a low and stable rate of inflation – the British economy enjoyed its longest and most sustained period of price stability since World War II.5 The establishment of the Bank of England Monetary Policy Committee in 1997, with independent control over monetary policy, reinforced the view that low inflation was now institutionalized in the United Kingdom. The Governor of the Bank of England was expected to write an explanatory letter to the Chancellor of the Exchequer if inflation deviated more than one percentage point from the target. When I joined the MPC in the autumn of 2006, nearly a decade had elapsed without one of these letters being written – though the first was despatched in March 2007, and thirteen more have been written since then!

The United Kingdom was not the only economy experiencing these benign economic conditions. In the United States, there was also a belief that their economy had entered a prolonged period of sustained growth and low inflation known as the ‘Great Moderation’. Like the United Kingdom, this view was reinforced by a high degree of confidence in the ability of the central bank to maintain sustained economic growth and stable prices. In the early 2000s, under its chairman Alan Greenspan, the US Federal Reserve had cut interest rates aggressively to steer the US economy away from recession when the dotcom US stock market bubble burst. And in the mid 2000s there was great confidence in the ability of Greenspan’s successor, Ben Bernanke, to do something similar if the situation demanded it. Meanwhile, the establishment of the euro as a single currency was seen as a stabilizing force for the European economy – anchored by a European Central Bank modelled on the Deutsche Bundesbank, which had successfully held back inflationary pressures and countered economic volatility in the 1970s and 1980s.

Reflecting the mood of these times, the Bank of England hosted a major international conference in September 2007 aimed at understanding the sources of macroeconomic stability.6 It was highly ironic that as economists and policymakers gathered in London to understand why Western economies had become so stable, confidence in the Great Stability was being undermined on the streets of cities and towns across the United Kingdom. Queues were forming outside branches of Northern Rock as customers sought to take their money out of the bank. When the Bank of England and the UK government appreciated the severity of the crisis, they intervened to rescue Northern Rock. But a year later, in the autumn of 2008, the financial turbulence hit other much larger banks – including Royal Bank of Scotland, HBOS, Citibank and Lehman Brothers. By then, it was clear then that the era of the Great Stability had already come to an end.

The Global Financial Crisis: A rude awakening

The financial crisis of 2008–9 provided a rude awakening from excessively optimistic views about our ability to maintain a long and sustained period of economic growth. It was also a reminder that, however adept national economic authorities were, developments in the global economy were a potential source of economic instability. Indeed, even before I joined the MPC in 2006, it was clear that international rather than domestic factors were the main sources of volatility driving changes in UK monetary policy.

The MPC was established in 1997 just before the onset of the Asian financial crisis, which threatened the growth of the global economy. This was followed in the late 1990s and early 2000s by the dotcom boom and bust which had its roots in excessive optimism about the ability of information technology and the Internet to transform the prospects of the US economy. The weakness of the global economy in the early 2000s was reinforced by international political instability following the 9/11 attacks and then war in Afghanistan and Iraq. But just as the world economy emerged from this period of turbulence, we started to see surges in global energy and commodity prices. The price of oil, which had been stable at around $20/barrel for most of the 1990s and early 2000s surged to over $50/barrel in 2004 and hit $80/barrel in 2006 just before I joined the MPC. Two years later it had reached nearly $150/barrel.

When facing global shocks of this sort, a central bank in a single country like the United Kingdom can only do a limited amount to offset their economic impact. As long as the shocks are not too big, it is possible to keep the economy on a reasonably steady growth and low inflation track – which is what happened in most Western economies through the period from 1993 until 2007. But the global financial crisis exposed the limits of the ability of national authorities to stabilize economies in the face of such a severe global economic shock. Even though interest rates were cut to rock bottom levels and other emergency measures taken to stabilize the financial system around the world, a major world recession could not be avoided. Between 2007 and 2009, GDP fell in the G7 economies by over 4%, with the decline varying between 1.7% (Canada) and 6.6% (Italy and Japan) – leading to a rise in unemployment rose around the world.

To counter this severe economic downturn, policymakers unleashed a whole raft of measures to provide emergency support to their economies and stabilize the financial system. Governments took financial stakes in banks and allowed their borrowing to rise to cover this. Central banks cut official interest rates to rock-bottom levels. In the United Kingdom, the Bank Rate of 0.5% we set in March 2009 is the lowest seen in recorded history – lower even than in the Great Depression of the 1930s when the official rate of interest did not fall below 2%. Money was also injected into economies through central bank purchases of government bonds and other assets – under a policy with the unappetizing title of quantitative easing. And for a while governments were prepared to increase their spending and cut taxes to support a return to growth.

These policies succeeded in heading off a downward spiral in the global economy. But they have achieved only limited success in terms of a return to economic growth. In the Western world, economic stimulus has produced a recovery but ‘not as we know it’ (to adapt a famous quotation from Star Trek).7 Even allowing for some pick-up in 2014, growth in the major Western economies has not returned to the previous trend rate experienced before the recession, as Figure 1.1 shows. The only exception to this pattern is Germany, where growth was relatively subdued before the crisis.

Figure 1.1. Western growth pre- and post-crisis. Source: IMF, updated with PwC forecasts.

On average, the seven largest Western economies (the G7 nations excluding Japan plus Spain) grew by 2.7% per annum in the decade before the financial crisis. In the first five years of economic recovery, 2010–14, the same group of economies is likely to grow at just over half that rate, even allowing for some growth rebound in 2014. The slowdown is less marked in North America than in the major European economies. And countries in southern Europe have seen the biggest deterioration in economic performance.

This is not just disappointing performance by comparison with the pre-2007 growth period. It is also slow growth by comparison with previous economic recoveries in the major Western economies. Average economic growth in the United States in the first five years of this recovery (2010–14) is expected to be 2.2% per annum, compared with 3.8% and 3.3% in the equivalent phases of the 1980s and 1990s recoveries. In the four major European economies, the IMF expects to see annual growth of just 0.9% in the period 2010–14, which is around half the growth rate achieved in the equivalent five years in the 1980s and 1990s (2.0% and 1.6%).

The global financial crisis has clearly played a part in contributing to this experience of slow growth – both in terms of the big shock it delivered to many economies and the impact it has had on access to finance. The pre-2007 world of ‘easy money’ – in which the financial system was providing a substantial tailwind to economic growth – has been replaced by a much more cautious and restricted banking system in many countries. But this change in the financial climate has not been the only factor at work. In Chapter 3 we will discuss how a combination of economic headwinds is contributing to this New Normal of disappointing economic growth in the West. There are, however, a number of myths and misperceptions have grown up about the reasons for disappointing growth in the major Western economies. And it is helpful to dispel some of these at the outset.

Myth 1: Global growth is weak

The first myth is that disappointing growth in the major Western economies reflects a weak global economy more generally. That is not true. Across the world economy as a whole, real economic growth is averaging close to 4% over the course of this recovery8 – not as strong as the peak years in the mid 2000s when the world economy was booming, but very respectable by comparison with historical trends. The slowdown experienced in the West has not been shared by the leading emerging market economies, as Figure 1.2 shows. In the emerging and developing world, economies have generally bounced back to the strong rates of growth they were experiencing before the crisis. Indeed, the IMF is expecting the same rate of growth in the emerging market and developing economies in the five years to 2014 as we saw in the decade to 2007 – nearly 6% per annum.

Figure 1.2. Robust growth in emerging economies. Source: IMF World Economic Outlook.

In the immediate aftermath of the financial crisis, there was also a concern that the world economy would lapse into deflation – a situation where the money value of spending stagnates or declines and where prices fall. Deflation was a feature of the depression of the 1930s, with US consumer prices falling by a quarter between 1930 and 1933. But these fears have not been borne out; instead the value of world economic output continues to expand, measured in terms of its most widely used currency, the US dollar. At the start of this century, the total value of economic activity in the world economy was $32 trillion. By 2008, this figure had nearly doubled to $61 trillion, a remarkably rapid rate of progress, averaging over 8% a year. After a brief dip in 2009, the size of the world economy has now expanded to an estimated $74 trillion in 2013. And by 2018, the IMF estimates that world GDP will be worth $97 trillion – around three times as much as at the turn of the century.

Despite a major global financial upheaval, the money value of output in the world economy has tripled in size in less than two decades. And it is inflation rather than deflation that has been the bigger problem as a result. This has been particularly true in emerging markets and developing economies, where growth has been strongest and consumer prices have risen on average by 6–7% in each of the last three years. One of the key drivers of inflation across the world economy in recent years has been rising energy, food and commodity prices. Since the early 2000s, whenever there has been a sustained pick-up in global growth, we have also seen a surge in the price of oil and many other commodities traded on world markets, including foodstuffs. This has happened repeatedly: in 2003–5, 2006–8 and in 2010–11.

In the major Western economies this has created bursts of the ‘wrong’ sort of inflation. We have been used to seeing inflation as a by-product of strong growth in our own economies. But imported inflation from rising energy and commodity prices squeezes consumers and business profits and hence acts as a dampener to growth in the short term. This squeeze has aggravated the problem of sustaining recovery since the financial crisis. And in countries which have seen a large fall in their exchange rate – like the United Kingdom – a devalued currency has added to the rise in imported inflation and the pressures on consumers to hold back spending.

Myth 2: Fiscal austerity to blame

A second myth that has grown up around disappointing Western growth is that it is primarily due to austerity – a squeeze on public spending and/or higher taxation – as governments seek to reduce their borrowing and debt levels. This view is particularly prevalent in the United Kingdom and in a number of other European countries, where efforts to restrain public spending have attracted a lot of news coverage and public debate.

It is true that government spending has not being contributing to growth in recent years. That is not a great surprise. Public borrowing levels were allowed to rise sharply in 2008–9 as the downturn eroded tax receipts and public spending was boosted in many countries to stabilize the economy. In 2009, public borrowing reached nearly 12% of GDP in the United States, 11% in the United Kingdom and over 6% of the national output of the euro area economies. These are unsustainable levels of borrowing which have pushed up government debt sharply and a period of spending restraint is therefore needed to restore stability.

But the notion that government spending is dragging down growth through austerity, either in the Western economies more generally, in the euro area or the United Kingdom, is misleading. Figure 1.3 shows that for the OECD economies as a group9, for the euro area and for the United Kingdom, real government spending on goods and services has been broadly flat after increasing quite significantly in 2008–9. The country where government spending has been cut back most noticeably in real terms is the United States. And yet the United States has been one of the better-performing Western economies in recent years, which casts further doubt on the view that fiscal austerity is responsible for weak growth.

Figure 1.3. Public expenditure in advanced economies. Source: OECD Economic Outlook.

The main source of the weakness of growth of demand in the Western economies is not from the public sector but from private consumer spending. There are various ways through which lower public spending can affect the willingness of consumers to spend – through its impact on public sector pay and the payment of pensions and benefits – but this does not appear to be the major cause of weak consumer spending. Nor can higher taxes be blamed – across the OECD economies the average tax burden as a share of GDP in 2013–14 is no ­higher than in 2007–8. There are other more important factors which have been squeezing consumers and making them more reluctant to spend, which are discussed in Chapter 3.

Myth 3: Not enough monetary stimulus

So if governments are not to blame for weak Western growth, what about central bankers? Could monetary policy have done more to restore growth to its previous trend? As we discussed above, monetary policy was used very aggressively in the depths of the financial crisis in 2008–9 to combat the negative trends in the major economies of the Western world. Official interest rates were reduced to near-zero levels across Europe and in North America. Beyond that, central banks have inflated their balance sheets as they have sought to pump money into the economy by purchasing government bonds and other assets. Former Goldman Sachs Chief Economist Gavyn Davies estimates that total central bank assets and liabilities have more than doubled in size in relation to the world economy since the early 2000s – rising from 14% of world GDP then to 32% now.10 The bulk of this expansion took place in response to the financial crisis.

Initially, these policies were successful as they stabilized economic and financial conditions and provided the basis of a recovery starting in the second half of 2009. But subsequent efforts to reinvigorate growth since 2010 with further rounds of quantitative easing in the United States and the United Kingdom have not worked. The US Federal Reserve launched its ‘QE2’ policy in late 2010 and continued it through the first half of 2011. But this did not prevent the US growth rate slowing down to below 2% per annum in 2011. A further round of asset purchases which started in mid-2012 – ‘QE3’ – also appears to have had a limited effect on economic growth rates. In the same way, additional injections of quantitative easing by the Bank of England in late 2011 and 2012 did not prevent the economy slowing to almost a standstill over that period.

Some argue that the outcomes in the United States and the United Kingdom would have been even worse without these injections of additional money or that lags in the system have delayed their impact. I would dispute these arguments. But, in any case, these continuing programmes of central bank stimulus have clearly not been able to restore the growth rate back to its pre-crisis trend. This is in line with the consensus view of economists since the 1980s that monetary policy is best suited to ironing out short-term fluctuations in the economy and does not have the potential to influence growth trends over longer periods. Longer-term growth reflects deeper fundamentals relating to the capabilities of our economies – the capacity of businesses to innovate and develop new products and processes, their confidence in investing in new facilities, the skills of the workers they employ, and their ability to provide the goods and services which the public demand.

The reality: It’s the New Normal

A common theme underpinning these myths and misperceptions about our problem of slow growth in the West is that there is an external force holding our economies back. So if only that dampening influence could be removed, growth could bounce back to the rates we enjoyed before the crisis. In other words, if the world economy picked up, if the government abandoned austerity, or if central banks were able to do more – everything would be all right.

But that is not the case – which is now being more widely recognized. The forces shaping our New Normal of disappointing growth in the Western world are more deeply rooted within our economies and cannot be relieved easily. As a result, we need to be more willing to adapt to our current situation and take a longer-term view of how we might improve economic prospects. But before we turn to a more in-depth analysis of our New Normal economy, it makes sense to consider the lessons of history.

In the words of the Spanish philosopher George Santayana: ‘Those who cannot remember the past are condemned to repeat it.’ So the next chapter considers what we can learn from the two previous episodes when we have seen serious financial and economic turmoil in the major Western economies and a big dislocation of growth: the 1930s and the 1970s.